Microsoft-Nokia: A good deal that came too late

PALO ALTO, Calif. - Windows is dead. Let's all salute it - pour out a glass for it, burn a CD for it, reboot your PC one last time. Windows had a good run. For a time, it powered the world. But that era is over. It was killed by the unlikeliest of collaborations - Microsoft's ancient enemies working over decades, in concert: Steve Jobs, Linus Torvalds, and most of all, two guys named Larry and Sergey.

This week, Microsoft announced its unsurprising, $7.2 billion plan to buy Nokia's smartphone division. Nokia is the world's largest manufacturer of phones that run Microsoft's Windows Phone operating system (which is a bit like pointing out that, at 5-foot-6, I'm the tallest member of my immediate family). Microsoft is buying Nokia to control both the hardware and software in its devices; this move, Microsoft promises, will improve the phones themselves and make them easier to sell.

But this is the antithesis of the company's Windows strategy. Though Microsoft insists otherwise, when this deal is done, the thing sold as Windows won't be what it's always been - it won't be software that that runs on lots of companies' hardware, a platform to unite disparate manufacturers' devices. Instead, Windows will be much like Apple's operating systems, iOS and Mac OS. Windows will be proprietary software attached to proprietary hardware - Microsoft's code running on Microsoft's devices.

In a document that lays out the "strategic rationale" for the deal, Microsoft makes a stirring case for vertical integration: for a single company that makes both mobile software and hardware together. By purchasing Nokia, Microsoft says it will be able to create better phones by reducing "friction" between hardware and software teams that now reside in separate companies. Combining the companies also improves marketing "efficiency" and "clarity" - Microsoft can sell a single Microsoft device that bakes in the best services from both firms (Skype, Office, Nokia's mapping systems).

Finally, vertical integration helps Microsoft's bottom line. Today, for every Windows-powered phone that Nokia sells, Microsoft gets less than $10 in software licensing fees. When it owns Nokia, Microsoft will be able to book profits on hardware, too. Rather than make less than $10 per phone, it will make more than $40.

Steve Jobs long pushed against Bill Gates' idea that hardware and software should be made by different firms. And back in the PC era, Gates was right. Gates recognized that most computer users didn't understand hardware. We couldn't tell the difference - and didn't really care much about - the processors, drives, displays, and other physical components that made up one PC versus another. As a result, making PC hardware was destined to be a bruising commodity business, with low brand recognition, constant price battles and dwindling profits.

But software, Gates saw, was a different story. Software had a face. Software imprinted itself on users - once you learned one Windows PC, you understood every Windows PC. Unlike hardware, software enabled network effects: The more people who used Windows, the more attractive it became to developers, which meant more apps to make Windows computers more useful, which led to more users, and on and on. Finally, software was wildly, almost unimaginably profitable. After writing code once, you could copy it endlessly, at no marginal cost, for years to come - and make money on every single copy you sold.

But mobile devices altered that calculation. Today, hardware matters. Unlike in a PC that you kept hidden under your desk, the design of your mobile device affects its usefulness. Things like your phone's weight or the way your tablet feels in your hand are all important considerations when you're buying a device; you won't choose a phone based on software alone, and you might pay a premium for a device that's particularly well-designed. In the mobile world, as Apple has proved, hardware can command just as much of a profit as software.

You might argue that once the basic design of a good phone or tablet becomes well-known, lots of companies will copy it, and that hardware will again become a commodity. That's the tide Apple is now battling against. At some point mobile components will become good enough and cheap enough that a $50 phone might function just as well as a $100 or $200 phone. When that happens, people will again start choosing devices by price, and hardware profits will dwindle to nothing. And, as happened with PCs, software, not hardware, will become the industry's dominant business.

All that may well occur. (The fear of commoditized hardware explains Apple's languishing share price.) But if mobile hardware does become a commodity and software once again becomes the determining factor in your choice of phone, we won't see Microsoft profit from the shift. That's because, in the last five years, a brutal, profit-destroying force has emerged in the tech world: Android.

Google's mobile operating system - which is based on Linux, the open-source OS whose fans had long dreamed would destroy Windows - is free. Any mobile phone manufacturer can use and alter Android however it pleases. This accounts for Android's stunning market share - close to 80 percent, according to IDC - and that market share gives Android the benefit of the network effects that once worked so well for Microsoft. Nokia was paying Microsoft $10 for every phone it sold, and in return it got an OS that can't even run Instagram. Microsoft says that it wants to keep licensing Windows Phone to other manufacturers even after it purchases Nokia, but because they can always choose Android (which runs Instagram and everything else), few phone-makers are likely to take it up on that deal.

That's why the Nokia purchase signals the end of Windows as a standalone business. There are now only two ways to sell software. Like Apple, you can make devices that integrate software and hardware together and hope to sell a single, unified, highly profitable product. Or, like Google, you can make software that you give away in the hopes of creating a huge platform from which you can make money in some other way (through ads, in Google's case).

But you can't do what Windows did - you can't make profitable software on other companies' commodity hardware. Thanks to Android, code is now a commodity, and Windows is dead.